Friday, 8 June 2012

Automatic Stabilisers and Discretionary Fiscal Policy

Antonio
Fatás makes a significant point
about countercyclical fiscal policy. The set of economists and policy makers
who think favourably of automatic stabilisers (the fact that taxes go down and
government benefits go up in a recession, and vice versa) is very large. The
set that think discretionary countercyclical fiscal policy is desirable is much
smaller. Yet they involve the same mechanisms. It would be quite illogical to
claim that discretionary fiscal policy will have no impact on output, and at
the same time argue that automatic stabilisers do help stabilise output.

However,
there are two good reasons I can think of why you might be in favour of
automatic stabilisers but be against discretionary countercyclical fiscal
policy. The first is rather dull. Automatic stabilisers kick in fairly quickly:
if you become unemployed, you stop paying income tax and start receiving
unemployment benefit almost immediately. Discretionary fiscal policy, on the
other hand, is subject to important implementation lags. These may be political
– a bill has to be passed by politicians – or institutional – projects need to
be found to spend the money on. If we really wanted to conduct discretionary
fiscal policy on a regular basis then these lags could be considerably
shortened by making institutional changes, but in the absence of these changes
the lags are important. (They can be partially offset by expectations effects,
but clearly there is no point stimulating the economy after it has already
recovered.) Campbell Leith and I did some calculations to assess the importance
of these lags in some (unsubmitted and therefore unpublished!?) work here.

The
second good reason is more interesting. Discretionary fiscal action can be
asymmetric. Governments may be very keen to cut taxes and increase spending in a
downturn, but less interested in doing the opposite in a boom. Automatic
stabilisers, on the other hand, are pretty symmetrical. As a result,
discretionary fiscal policy can lead to deficit
bias. I argued
(see, in particular, section 4) more than a decade ago that, of the many
arguments that can be used against discretionary countercyclical fiscal policy,
these two were probably the most important for economists precisely because
most economists were in favour of automatic stabilisers.

Ironically,
that asymmetry in countercyclical fiscal policy may make a good deal of sense
in a world of low inflation targets where there is a danger of hitting the zero
lower bound (ZLB) for interest rates. When there is not that danger, we rely on
monetary policy to do our business cycle stabilisation, for all the reasons I
outlined here.
If there is a good chance that we could hit the ZLB, on the other hand, it
would be prudent to undertake expansionary fiscal policy as a precautionary
measure. (It should be undertaken in advance partly because of implementation
lags.) That means that in normal times (i.e. when we are not at the ZLB) it
makes sense to gradually reduce the stock of government debt – even if it is
not thought excessive – so as to allow for expansionary fiscal policy when the
economy is hit by large negative shocks. The argument is elaborated here.

For a
member of a monetary union, however, countercyclical fiscal policy should be
symmetrical, and it was the failure to understand this which was in my view
a major cause of the current Euro crisis. In that 2000 paper I
argued that one way of avoiding deficit bias would be to give central banks the
ability to temporarily change a small number of fiscal instruments. Perhaps not
surprisingly, I have found
this proposal to be rather unpopular among politicians. However, I think it
would have had considerable merit if it had been part of the Euro architecture.
If nothing else, it would have given something for all those national central
banks to do after the ECB was formed. More seriously, it might have helped
reduce the scale of the crisis the Eurozone now finds itself in.

5 comments:

"...clearly there is no point stimulating the economy after it has already recovered."

That's not as clear as it looks, to me at any rate. If there is a fiscal rule such that the government always boosts the economy in a downturn, even though there is a significant lag, that ought to mean that slumps are less severe. An unexpected fall in leading indicators will prompt firms to plan for the inevitable boost which will follow "in due course, when the necessary formalities have been completed" etc. I got this idea from reading J-P Benassy's Money, Interest and Policy so I'm pretty sure it's respectable macro.

That quibble aside, I'm glad to see somebody standing up for fiscal policy. I appreciate the blogging of Nick Rowe and Scott Sumner but their anti-fiscal stuff annoys me at times.

I think you are clearly right if the government spending comes on stream while monetary policy is constrained, and the economy is still underutilising resources. However, if it comes on stream when the economy is back at the natural rate, then in principle the monetary authorities could offset its impact, and so firms today would be indifferent. On Nick and Scott, I couldn't possibly comment!

Simon: "However, if it comes on stream when the economy is back at the natural rate, then in principle the monetary authorities could offset its impact, and so firms today would be indifferent."

I think that's probably right for firms, but it would be wrong for households, in a standard New Keynesian model. If G is expected to be higher when the economy is back at the natural rate, then C would be expected to be lower when the economy is back at the natural rate. The consumption-Euler equations then says that current C would be lower, for a given current r, which means it would make the recession worse. (You probably already know this.) So an increase in G that comes too late would be a bad thing.

My guess is that J-P Benassy (who is a great macroeconomist) is assuming that the fiscal boost that comes too late will work to push the level of output *above* the natural rate (that it will not be offset by the central bank)?

Simon: fair points. I think there is maybe a third argument for automatic stabilisers vs discretionary spending. I wouldn't put too much weight on it, but it's worth making. For the same aggregate level of spending, automatic stabilisers *prevent* a lot of micro-level disruptions in individual spending plans, while discretionary fiscal policy will *usually* *create* a lot of micro-level disruptions in individual spending plans. That's a supply-side argument, which is why I'm a bit wary of making it, but discretionary fiscal policy might cause an upward shift in the SRAS curve relative to automatic stabilisers.

This is more of a question than a statement, but when talking about stability and control, it is important to understand how PID control loops work, as Phillips discussed way back in the 50's, yet I don't see much discussion of control loops in discussing stabilization. For instance, the Taylor rule seems to completely ignore such issues. (Interesting IEEE paper on Phillips, PID loops and his hydro-mechanical 'Moniac' here.http://oro.open.ac.uk/7942/

Essentially, the PID loop in an autopilot or other stability control device requires an initial proportional input, sufficient to prevent further divergence, with an integrated additional correction to return the desired condition, followed by a derivative correction as the desired value is approached, to reduce oscillatory tendencies. Phillips said that if the overall system has a tendency to oscillate, "...the integral element in the policy should be made very weak or avoided entirely, unless it can be accompanied by sufficient derivative correction to offset the destabilizing effects..."

By those guidelines, the overall US stimulus has just barely provided the initial proportional input, and there is very little integral element to return it to its initial condition. However, the political demands are to rapidly return to the desired economic conditions. The uneven stimulus/bailout to the financial sector has caused it to complete a rapid return to former levels, but now appear to be declining again. Given the current state of the US Congress, I don't think there is any hope of a rational policy/PID loop approach to either monetary or fiscal stimulus, and if Europe follows suit, the world economy, according to Phillips, is in for a real roller coaster ride.

I've written a brief post about control, risk and economic policy, 'Hedging the Apocalypse' at http://somewhatlogically.com/?p=598 It also contains references and links to some work that I am doing in conjunction with the Dominican University to develop a simplified policy 'flight simulator' to look at the economic effects of environmental and resource policy, in conjunction with their Green MBA program. The work was very much inspired by Phillips model and the concept of stocks and flows, but uses a fluid dynamics analog. It turns out that fluid dynamics are very Keynesian.

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